One Indicator for Market-Crushing Returns

Partner up with highly invested CEOs.

Can you pick winning stocks based on a single, publicly available figure? The notion seems completely absurd. If it existed, how could the entire fund management industry overlook such an indicator? However, there truly is a simple yet powerful sign to identify stocks that outperform the index: CEOs' ownership of their companies' stock.

I looked at the 20 stocks in the S&P 500 with CEO ownership greater than 5%, and found that an equal-weighted portfolio of these stocks produced a total return of 180.4% in the 10 years ended Nov. 1 of this year. During the same period, the S&P 500 returned nothing -- even with dividends factored in.

The list contains several high-profile stocks with well-known founder-CEOs at the helm, including Amazon.com(Nasdaq: AMZN), Oracle(Nasdaq: ORCL), and Dell(Nasdaq: DELL). However, the top performer is decidedly low-profile: Airgas(NYSE: ARG), with a stunning 1,026% return. Also in the top five: Hess Corporation (240%) and Leucadia National(NYSE: LUK) (234%)

Can CEO stock ownership alone explain superior returns? Perhaps I was simply looking at a statistical mirage. To make sure that these returns weren't simply a function of stock sector or market capitalization, I ranked the stocks in the S&P 500 by level of CEO stock ownership relative to the other stocks in their sector. (In a second run, I ranked them relative to other stocks within specified market cap ranges.)

The result held. Stocks with the highest level of CEO ownership still performed best, and they smashed those with the lowest level of ownership. The same held true when controlling for market capitalization:

Sample Group

Average Total Return, 10 years to Nov. 1, 2010

Market Cap-Weighted Average Total Return,10 years to Nov. 1, 2010

S&P 500, Highest Quintile of CEO Stock Ownership*

238%

317%

S&P 500, Lowest Quintile of CEO Stock Ownership*

123%

(9%)

S&P 500

186%

0%

*The top or bottom one-fifth among CEO ownership for each sector. Source: Author's calculations, based on data from Capital IQ, a division of Standard & Poor's.

Still, I remained skeptical of the results. Could the market really be overlooking something this obvious? Then I came across a June 2010 paper, CEO Ownership, Stock Market Performance and Managerial Discretion, in which the authors performed comprehensive tests on a large data set. They conclude:

We find that portfolios of firms with high managerial ownership strongly outperform the stock market... These results show that even a simple low-cost buy and hold strategy based on managerial ownership would have earned abnormal returns that are significant in statistical as well as in economic terms.

"Abnormal" is academic gobbledygook for "market-spanking," and as the authors stress, investors could have captured these returns in the real world. It certainly would have been worth their while. In some cases, the authors found that the excess return from stocks with high levels of CEO ownership was more than one percentage point per month.

The authors also found that the companies with a combination of high CEO ownership and high managerial discretion produced the highest excess returns. In other words, when the incentives of the person at the top of the company are aligned with shareholders', and that person has real leeway in running the business, shareholders reap premium returns.

There is perhaps no better example of this than Berkshire Hathaway(NYSE: BRK-B)(NYSE: BRK-A), the holding company built by Warren Buffett. Until he donated part of his stock to charity, Buffett was Berkshire's largest shareholder, and he has enormous freedom in steering the conglomerate. In turn, Buffett does not interfere with the CEOs of Berkshire's operating companies, who are free to run their businesses as they see fit. That very powerful dynamic has doubtless contributed to Berkshire's market-crushing returns.

The Motley Fool's Million Dollar Portfolio, a real-money portfolio that owns the best stock picks from across the Fool's newsletters, has developed a framework for evaluating CEOs, and stock ownership is one of its four criteria. It's no surprise to find Berkshire among the portfolio's biggest positions. Today, the service will open to new members for the first time in a year. If you'd like to find out more about putting this market-beating service to work for you, simply add your email address in the box below.